As the Indian equity market touched its seven-month low last week, the negative impact was felt on stocks from various sectors. The BSE mid-cap index, which fell to its one-year low, lost about a quarter of the gains from its 2010 peak . While the latest earnings season has demonstrated a broad-based margin pressure on the earnings of companies, including on those from the mid-cap and large-cap space, in the backdrop of rising interest and raw material cost, the business situation looks tougher for mid-cap companies.
Our analysis of close to 125 companies constituting the BSE mid-cap index that have already announced their December quarter results reveal that while the mid-cap companies have performed as moderately as their large-cap counterparts, they are likely to feel more pain of any significant rise in interest and raw material cost hereon.
We examined the companies? financials for 12-months ending June 2009 to make sure that the impact of the latest recession was encompassed.
Our analysis revealed that the mid-cap companies showed a remarkable recovery on a yearly (12-month) basis between June 2009 and December 2009, clocking a compound growth rate of 5% and 9% in operating profit and net profit, respectively. While revenue during the periods showed a slight decline, earnings were well supported by a decline of about 2% in total expenditure due to lower raw material costs and other cost-cutting measures put in place. The net earnings were also cushioned by a moderate growth of about 1% in interest cost during the period.
As a result, both operating margin and net profit margin of our mid-cap sample showed a healthy gain of 250 and 137 basis points, respectively. A combination of moderate interest cost and robust earnings resulted in a sustained improvement in the interest cover of the sample until the year ending September 2010.
The interest cover remained flat for the year ending December 2010 to join the flattening operating margins, which seemed to be under pressure due to a rise in input cost after the recovery in most input materials.
Generally, higher interest cost affects the net profit of any company, but for a mid-cap company it has a greater bearing. This is proved by our sample, for which average interest cost comprises 17% of revenues while working capital constitutes close to 15% of net sales. Given that these companies witnessed a compound growth rate of 23% in their working capital requirement, higher interest cost could have a significant indirect effect on their future earnings.
This apart, the recent spike in basic materials along with escalating prices of agricultural inputs could further impact the operating efficiency of the mid-cap space. Also, on an average, raw material costs contribute about 25% to their total cost.
In conclusion, it appears that the coming months could be a difficult period for mid-cap companies, for the rising inflation and subsequent higher interest rates could substantially eat into their earnings. Moreover, any slight under-performance of overall economy (GDP growth) could bring in testing times for the mid-cap group.
The sample set of midcap companies was arrived at by choosing companies that have already announced their latest-quarter results as well as for which the latest balance sheet for the accounting year ending March 2010 was available. We also made sure that the sample set was fairly balanced as to include companies from diverse sectors including capital goods, IT, metals & mining, banks & financial services, consumer durables & FMCG, healthcare, entertainment and auto ancillary, to name a few.